Why the Reserve Bank is boosting its activity in short-term money markets

Dwindling liquidity in short-term money markets has prompted the Reserve Bank to lift its participation as a means to limit volatility and keep short-term rates near the official cash rate.

In the latest Reserve Bank Bulletin, analyst Andrew Kendall reports finding liquidity had declined across different markets to varying degrees but had been manageable so far. In short-term money markets, which are a key channel for transmitting monetary policy decisions, Mr Kendall found reduced liquidity in foreign exchange swaps had heightened volatility, which traders put down to increased regulation stifling activity and limiting the ability of participants to use their balance sheets in arbitrage trades to bring rates down in line with the OCR.

"The Reserve Bank has responded to the reduced liquidity and increased volatility by transacting more in the foreign exchange swap market, in an attempt to 'replace' some of the lost liquidity," the report said. "While there are still periods of volatility, generally the increased participation in the market has improved market conditions thus far and allowed short-term rates to trade closer to the OCR."

Still, Mr Kendall said if liquidity continues to deteriorate, it will become harder for the Reserve Bank to respond due to the size of its balance sheet and need to maintain prudent risk management.

In November, the Reserve Bank noted the liquidity deterioration of market liquidity in its financial stability report, saying there was a risk that funding costs could increase.

Kendall's note found New Zealand government bonds showed mixed results, with the number of transactions, turnover and spreads indicating no change in liquidity though average trade sizes had worsened in recent years, and market makers said they had witnessed reduced participation from investment banks as increased regulation raised the cost of capital.

"We conclude that while the New Zealand bond market liquidity has not contracted significantly in recent years for investors, this masks an underlying fall in liquidity being experienced by market makers," Mr Kendall said. "Further, while not directly measurable, it appears that the resilience of liquidity has diminished in line with the lower participation from market makers."

On bank funding liquidity, Kendall said he found it had modestly diminished in the past year, largely due to greater market volatility and that lenders' costs were manageable given regulations requiring them to source more funding domestically, and more conservative approaches to risk.

RAW DATA: Reserve Bank Bulletin

(BusinessDesk)